Secondary Return Attribution

September 12, 2019

These days, it seems like secondaries appear to be attractive because of their discounts. After all, what's not to like about the potential for "day one" returns and resulting J-curve benefits? But, success in secondaries depends on more than just love at first sight.

An underappreciated fact about secondaries: Discounts are generally not the biggest driver of returns. The chart above illustrates this. The orange line represents your secondary return if you had bought the entire universe of mature buyout funds (>=5 years old) at prevailing market prices during each given year. The columns show what portion of this return came from discount versus appreciation.

As you can see, the majority of secondary returns have come from post-close appreciation for almost every purchase year. Over the long run, the discount has contributed barely a third of secondary returns. And, this takeaway only gets stronger if a buyer were to include funds fewer than five years old and/or were to underweight tail-end funds, which command significant discounts but generally entail limited upside and greater risk.

Discounts have driven the majority of returns in only two purchase years, and it is worth touching on these exceptions. One is 2009. Not only were bid discounts uniquely large that year, but those bid discounts turned into even larger closing discounts—thanks to significant market appreciation in the months between bidding and closing. Note, however, that even in a year viewed by many as an outlier, appreciation still accounted for almost half of the return.

The other exception is 2017. This is a good example of how a discount drives a secondary’s early performance but gives way to appreciation as the secondary matures. One need only compare 2017 to 2014-2016 to see how the discount’s significance tends to trail off over time.

What does this mean for your secondary strategy? For one thing, secondary investors should not place undue emphasis on discount at the expense of quality. The caliber of both the general partner and the portfolio will determine go-forward appreciation, which we now know has been the bigger factor in secondary returns. With respect to the portfolio, buyers should consider not only the growth trajectory of the companies, but also how they are valued. After all, what good is a discount to NAV if the NAV is inflated by aggressive underlying company valuations? Nobody likes a “DINO” (discount in name only). To assess quality on these dimensions, a secondary buyer must have the relationships and information to know the GPs and truly understand the assets.

All of this is not meant to completely “discount the discount.” Entry price and appreciation are both keys to success, and the relative importance of the two can depend on the individual deal, the point in the cycle and other factors. But as a general matter, investors should know that their experience with secondaries will depend greatly on the substance of what they are buying—not just the discounts that first catch the eye.

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